What Is Liquidity Risk Management?

There are several risk management tools to protect liquidity.

Liquidity risk management is a method used by investment portfolio managers to hedge the risk of being unable to sell their large portfolio positions in a rapidly developing market. In other words, this is a way that investors insure against large losses in stakes of companies or other assets that have few buyers (or sellers) at a given time.

Liquidity

Liquidity is a relative term that connotes the idea of being able to exit or enter your portfolio position at the time and price that you prefer. Some markets, such as the FOREX market, trade $3.5 trillion of value every day. This means that even the largest investor will be able to sell or buy a position at a moment's notice at the market price. For an investor in a smaller market, such as penny stocks, one relatively small investor can change the entire market price in a negative direction.

Portfoilo Construction

To avoid the liquidity trap, investors use several methods of portfolio construction. Most importantly, investors diversify their holdings. For large investors, they do not assign more than 5 percent of their total portfolio to any one position to avoid the risk of losing too much on any asset. Large investors also prefer to invest in large, highly traded markets. The FOREX market is the largest in the world. While the Philippine stock market rose a rapid 58 percent in 2010, the trading volume is minuscule compared to U.S. exchanges and, therefore, poses large liquidity risk.

Hedging

Hedging is another risk management tool. Investors purchase non-correlating or negative contracts as insurance on their large positions. For example, if a trader has a large stake in a company, he may buy some inexpensive put options as protection against a rapid drop in price. That is because the value of put options rise when the price of the company falls. Hedgers can also buy an exchange-traded fund or other correlating asset to help protect against liquidity risk. They use correlations to trade more active stocks when their specific one has too little liquidity.

High Frequency Trading

In recent years, the pit traders of the New York Stock Exchange and Chicago Board of Trade have been replaced by electronic market makers, such as those on the NASDAQ. With computer power growing exponentially, traders have endeavored to high frequency trading. This trading method allows firms to rapidly buy and sell securities in microseconds, leading to an explosion of liquidity. In addition, the spreads (difference between the bid and offer price) have contracted to pennies for any large exchange-listed security. With these low spreads and easy buying or selling, liquidity risk has diminished on U.S. markets.

References

• Advance Trading: High Frequency Trading and the Evolution of Liquidity in US Equity Markets; Fred Federspiel and Alfred Berkeley; Aug. 25, 2009
• Daily Finance: Best and Worst Global Stock Markets of 2010; Dan Burrows; Dec. 29, 2010
• Liquidity Risk: Hedging Future Commodity Price Risk Can Damage Your Company's Liquidity; Ron Wells; March 2010